Question

Commercial banks are regarded as money creators because: (Choose the correct option)

• A. they purchase securities from the Central Bank.
• B. loans provided by them create deposits.
• C. they act as a banker to the government.
• D. they regulate the lending rate in the economy.

Hint:

Commercial banks create money through the loan-deposit cycle. The more they lend, the more deposits they generate, which expands the money supply without printing new currency.

Answer 1

The Correct Option is B

Commercial banks play a crucial role in the creation of money in the modern economy. This process is known as credit creation or money creation. When banks give loans to individuals or businesses, they do not disburse the amount in cash. Instead, they credit the loan amount to the borrower's deposit account. As a result, new deposits are created in the banking system without printing new currency. This process expands the total money supply in the economy and is thus referred to as money creation by commercial banks. The bank loans become new deposits, and those deposits can again be used to issue further loans (after keeping a portion as reserve), thereby multiplying the money supply through the money multiplier mechanism. Let’s understand this with an example:
Suppose a bank receives a deposit of ₹ 1,000 and keeps a reserve of 10%. It lends out ₹ 900. The borrower then spends this, and the money eventually gets redeposited in another bank, which again lends 90% of that. This process continues and leads to a much larger expansion of deposits (money) in the banking system. Other options like purchasing securities from the Central Bank or acting as a banker to the government do not directly contribute to money creation in the economy.